Monetary Finance: Mechanics & Complications

Eight years after the 2008 crisis the global economy is still stuck with low growth, too low inflation, and rising debt burdens. Massive monetary stimulus has failed to generate adequate demand, and some commentators suggest that we are “out of ammunition” with which to counter deflationary pressures.

Money financed fiscal deficits –more popularly labelled “helicopter money” – seems to be one of the few policy options left. There is therefore considerable debate about how monetary finance works, whether it will be effective, and whether it would have adverse side-effects. This debate necessarily involves detailed issues relating to government, central bank and commercial bank balance sheets.

The papers posted here therefore aim to set out clearly the mechanics of monetary finance, to clarify specific technical issues, and to respond to questions raised.

Since I presented that paper a number of counterarguments or questions have arisen . On this blog page I will therefore post detailed responses .

One quite commonly heard argument is that the effectiveness of monetary finance might be offset by anticipation of an “inflation ta”. In particular it is asserted that monetary finance deficits might be no more stimulative than debt financed deficits, since anticipation of an “inflation tax” will have the same depressive effect on demand as Ricardian equivalent anticipation of actual taxes. The attached paper on “Why money financed stimulus is not offset by an inflation tax” explains why that logic is flawed.

Another crucial question which has arisen relates to the private sector asset counterpart to a consolidated public sector non-interest-bearing liability. It is obviously the case that the impact of money financed deficits will only differ fundamentally from debt-financed deficits if the additional monetary base created is permanently non-interest-bearing. This would seem to pose the question “Who will willingly hold non-interest-bearing money?” The attached paper provides the answer to that important question.

That answer is that while no household or company needs to hold non-interest-bearing money once market interest rates have returned to significantly positive levels, monetary finance is only fully effective if the commercial banks are required to hold non-interest-bearing reserves at the central bank. If instead the central bank paid interest on these reserves, the difference between money financed deficits and debt financed deficits would be very significantly reduced. But if the commercial banks are required to hold non-interest-bearing reserves, while companies and households earn interest on their deposits at commercial banks, this is equivalent to imposing a tax on commercial bank credit intermediation. A recent paper by Claudio Borio, Piti Disyatat and Anna Zabai argues that the impact of this future tax must (if anticipated) make money financed deficits no more stimulative than debt finance deficits. The attached paper on “Why a future tax on bank credit intermediation does not offset the stimulative effect of money financed deficits”, explains why Borio et al’s conclusion is wrong , even though their mathematics is undoubtedly correct.

I will post further papers on specific counterarguments and questions as this debate develops.